'Warren Buffett index' called the bursting of tech bubble - is another stock market crash on the way?
Published 18/08/2015 | 14:29
After enjoying six years of strong returns from equity markets, increasing numbers of professional investors are becoming more bearish and taking money off the table.
Should investors follow suit? Perhaps so, according to one valuation measure.
There are plenty of different ways to ‘value’ a market.
The four most basic and widely used – price to earnings, Cape, price to book and dividend yield.
But it could also pay to look at a less familiar measure - one used by the world's most famous investor, Warren Buffett.
It calculates whether the value of a country’s stock market is worth more or less than its annual economic output.
A figure of over 100pc suggests the market is overvalued, while those that score below 50pc are considered a bargain.
It is a simple and rather blunt measure. The logic, however, is sound - that the companies in a country, in general, will not be able to all outpace economic output of that country for long.
In an interview with Fortune Magazine in 2001 Mr Buffett said: “It is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago (before the tech crash) the ratio rose to an unprecedented level. That should have been a very strong warning signal.”
AJ Bell, the broker, crunched the numbers for the 14 biggest global economies, to find out which countries are overvalued, neutral or cheap.
The results, detailed in the chart below, show that America and Britain are the most expensive stock markets.
At the other end of the table Russia, India and Brazil are deemed the three cheapest countries to buy today.
It is worth pointing out that the measure has some critics. They argue that large businesses, particularly those listed on developed stock markets, often make more of their money internationally than in their domestic market.
So it can therefore be misleading unless you also compare the market's valuation today with its own history.
But even allowing for this, the test shows both America and Britain to be expensive. The Wilshire 5000, the US index viewed as the fairest to use because it is home to the most companies, has never been more expensive.
It scores 133pc, much higher than previous peaks in 2000 and 2007, of 112pc and 104pc respectively.
Britain’s FTSE All Share index valuation is also high by historic standards, at 124pc. Although this is marginally below its 133pc peak in 2000.
Russ Mould, of AJ Bell, said: “The data suggest that if corporate profits do come under pressure (owing to a recession, for example) then the US and UK markets could be left looking a bit exposed on the downside.
“According to Mr Buffett, once profits rise above GDP investors need to be careful. This makes sense as very few firms manage to make supra-normal returns for long: either the competition catches up with them, the customers revolt and demand lower prices or the regulator intervenes.”
For investors who aren't scared off, the simplest and cheapest way to invest is via tracker funds.
These are available for many markets around the world from companies such as Fidelity, Vanguard, SPDR and iShares.
The last two specialise in “exchange-traded funds” or ETFs, which are traded on the stock market just like a share. For the major markets you can pay a total annual charge on a tracker of 0.1pc or even less.